Eagle on the Street

  Inevitably, there was tension within a firm like Merrill Lynch—Lawyer, Lapidus, and others at the SEC called it a conflict of interest—over the need to generate commissions and the need to treat customers fairly. On one hand, it was in Merrill Lynch’s own interest to enforce the rules governing the behavior of stockbrokers. Unhappy customers were no bargain; at the least, they would take their business elsewhere, and at worst, they might sue the firm over rule violations. On the other hand, aggressive salesmanship was essential to making profits. The qualities that made Victor Matl a big producer—the way, as one customer told the SEC investigators, he “brainwashed” and “tranquilized” his clients—also made it likely that people would complain about him. That didn’t mean Matl had committed fraud. The question was whether a profit-driven firm like Merrill Lynch, which Shad believed had the industry’s best internal compliance system, truly was capable of detecting and responding swiftly to fraud when it occurred.

  It appeared to Lawyer and his staff as their investigation unfolded that for three years Merrill Lynch had done virtually nothing to restrain Victor Matl. From time to time, Matl’s immediate supervisor, Louis Trujillo, confronted the broker with customer complaints about his more egregious conduct. But Trujillo’s admonishings, and his occasional memos to Fisher about problems with Matl, provoked no action from above. Those customers who hired lawyers and pressed a case against the brokerage were either offered a cash settlement—always less than the amount of the customer’s losses—or were shunted into a Wall Street arbitration system for settling customer disputes that was stacked against them. Before investigator Bruns walked unannounced into the Merrill Lynch branch, the brokerage had paid $75,000 to six of Matl’s customers to settle legal claims.

  Bruns’s appearance and the document requests generated by Lawyer’s office suddenly changed Merrill Lynch’s attitude toward Matl. Senior lawyers from the brokerage’s Wall Street headquarters were dispatched to San Francisco. When the lawyers read the customer files, they threatened to fire Matl, but the broker begged to keep his job. “Please save me and give me a fresh start,” he wrote to Fisher just days after the surprise inspection. “I don’t want to be fired.” Merrill Lynch’s top in-house attorney, senior vice president and general counsel Stephen Hammerman, interviewed Matl for three hours and decided not to fire him. He and other Merrill Lynch executives were impressed by Matl’s sincerity and his considerable selling skills. Matl was told to tone down his aggressive tactics and attend a short training course in New York at his own expense. Meanwhile, the SEC investigation of Matl and Merrill Lynch proceeded in secret, with neither Merrill Lynch nor the SEC informing Matl’s old or new customers either of the probe or of the complaints.

  Merrill Lynch’s lawyers claimed afterward that the threat to fire Matl made him into a “changed man.” To the staff in Bobby Lawyer’s office, that claim seemed absurd. In any event, if Matl did change his ways, it wasn’t for long—in the midst of the continuing SEC investigation, new complaints came into the Merrill Lynch office about trades Matl allegedly had made without approval from his customers. After another brief round of hand-wringing inside Merrill Lynch, Matl was summoned to Robert Fisher’s office and fired. He later attended law school in San Francisco and applied for a summer job at the SEC. He was turned down.

  John Fedders faced a sensitive dilemma when the long, confidential memo authored by Lawyer and Lapidus recommending fraud charges against Merrill Lynch and its employees arrived at SEC headquarters in the summer of 1984.

  Fedders’s power as enforcement chief, and the trappings of his position in government that were so important to him, derived in large part from his continuing good relations with Jack Shad. On the other hand, ever since Citicorp, Fedders had been working assiduously to build morale and loyalty among his staff, and to a considerable degree he had succeeded. At the table in closed meetings, Fedders was supposed to be the staff’s champion. After reading Lawyer’s memo, Fedders had two reactions. First, he thought it needed to be rewritten—the arguments weren’t clear enough. Second, Fedders understood that the case Lawyer proposed against Merrill Lynch was likely to lead to conflict with Shad. And there was another memo circulating through enforcement that summer that was likely to exacerbate the conflict: Susan Pecaro and her supervisors in the enforcement division had decided to recommend fraud charges against Denny Herrmann and Smith Barney for failing to crack down on the naked-options trading in its Rhinelander office.

  At issue was a basic question about who was responsible for detecting and preventing fraud on Wall Street. The debate within the commission dated to the days of Stanley Sporkin and before, but recently it had acquired new life and urgency at SEC headquarters.

  Of all the changes Shad had attempted to implement, there were few that stirred emotions more than his effort to alter the standards by which the commission held big Wall Street firms accountable for wrongdoing by their employees. By recommending that charges be filed against Merrill Lynch because of Victor Matl’s conduct, Bobby Lawyer brought the conflict to a head.

  Shad was pulling the SEC back from close scrutiny of Wall Street investment firms’ operations, particularly in the area of stockbroker sales practices. It was axiomatic of Shad’s attitudes about Wall Street that he thought top executives at the major brokerages were almost uniformly honest and responsible. He believed, too, that the brokerages and the stock exchanges to which they belonged were well equipped to police themselves and that the SEC’s resources were too limited to meddle in individual stockbroker disputes.

  Federal regulation of stockbrokers and others at Wall Street firms was structured like a pyramid, with the SEC at the top, followed by the stock exchanges and the brokerage houses themselves. The SEC could bring civil charges against anyone or any firm if there was sufficient evidence of securities fraud. The SEC also routinely monitored some operations of registered brokerage firms through filings the firms made to the commission and occasional SEC inspections. As a practical matter, though, it was impossible for the SEC to closely examine all of a firm’s operations; during the period of Shad’s tenure at the SEC, the number of stockbrokers alone nearly doubled from slightly more than 200,000 to more than 400,000, while total SEC employment remained flat at about 2,000.

  Beneath the commission were the other layers of regulation and responsibility. Merrill Lynch, for example, was a member of the New York Stock Exchange, a so-called self-regulatory organization, or SRO. The exchange could discipline Merrill if the firm violated its rules for dealing with customers—rules that were approved by the SEC. Then, too, Merrill Lynch had certain obligations as an exchange member and a brokerage registered with the SEC to oversee the conduct of its employees.

  Increasingly, during Jack Shad’s tenure at the SEC, the burden of regulation in the sales-practice area was shifted from the commission down to the lower levels of the pyramid. The role of the self-regulatory organizations was emphasized more and more. Shad argued this made the regulatory system more efficient and effective, but no less vigilant. Transferring some responsibility to the stock exchanges would free up SEC resources for other programs, Shad said. The SEC would do its part by monitoring how well the stock exchanges handled their new duties. But a number of the SEC staff contended in internal debates that Shad’s approach only exacerbated the conflict within Wall Street firms between their drive for profits and their obligations to the law. Filing big cases and “jawboning,” or talking tough, about charging firms helped encourage compliance with the law. Conversely, shifting enforcement responsibility to Wall Street and resisting proposals to file charges against big brokerage firms for wrongdoing by employees in branch offices could lead to a breakdown of discipline at the largest investment firms, these SEC staff lawyers felt. It was an issue that was already taking on added significance within the commission because of the questions raised by Jack Hewitt’s probe of fraud allegations against Michael Milken and other employees in the Beverly Hills office of Drexel Burnham Lambert—
a branch office that wielded growing influence across the economy because of the giant junk-bond-financed takeover bids and other transactions it spawned.

  Ever mindful of shareholders, Shad sometimes argued that it was the stockholders of the defendant firm, rather than the executives charged, who got hurt most when a brokerage firm was charged, especially if the individual culprits already had been fired. In the absence of bad faith on the part of the company or high-level executive corruption, Shad opposed charges not only against large Wall Street firms but also against major industrial corporations. However, when it came to Wall Street he showed his deepest sentiments, arguing that it was unfair to charge a Wall Street house for bad deeds by an individual broker, because other firms would use the negative publicity to steal clients and because it was simply too costly to demand such perfection. It’s the brokerage house customers who ultimately will foot the bill for higher compliance costs, Shad argued. An irony of his position was that consumer-activist Ralph Nader, with whom Shad saw eye-to-eye on very few issues, had pushed during the 1970s for the SEC and other law enforcement agencies to charge individual executives with wrongdoing, rather than the firms and corporations where they worked. Nader thought that approach would give executives in positions of responsibility an incentive to avoid public humiliation by acting ethically and disciplining their institutions. If Shad had cast his own approach in Nader’s language, he might have found the SEC staff more receptive.

  But some among the commission staff thought Shad’s views were affected by his personal identification with potential defendants. Shad must have understood that during his days on Wall Street, had the SEC held senior firm executives responsible for wrongdoing by lower-level employees, he might have been named as a defendant in an enforcement case even though he personally had violated no laws. That assessment wasn’t just academic. Around the time that the Merrill Lynch and Smith Barney matters came before the commission early in 1985, Shad’s alma mater, E. F. Hutton, pleaded guilty to 2,000 counts of wire fraud in connection with a firm-wide check-kiting scheme to earn additional interest income through illegal overdrafting of bank accounts. As soon as the matter came to the SEC’s attention, Shad recused himself; the SEC proceeded to examine the chairman’s old firm without his input, due to the conflict of interest his participation would have posed. The Hutton money-management scheme, carried out in branch offices with the support of some members of senior management, began in 1980 while Shad was still at the firm, though there were never any allegations that he knew about the highly profitable, unethical scam. Ironically, while Shad’s approach to enforcement involved charging individuals rather than firms, both the SEC and the Justice Department charged the Hutton firm, but no individuals, leading to criticism that the regulators had failed—no scalp, no deterrent, the argument went.

  Bobby Lawyer wanted to charge both the Merrill Lynch brokerage and its employees, and in pressing his argument, he tried to utilize his geographical distance from Washington and secure regional office fiefdom to his advantage.

  Lawyer’s memo about the Merrill Lynch case circulated to Shad’s office, the office of the general counsel, and to other division directors. Meantime, Cary Lapidus wrote to Merrill Lynch’s lawyers in Manhattan informing them that the staff had decided to recommend fraud charges against the brokerage. Merrill Lynch was invited to make a so-called Wells submission, named for an attorney who originated the idea—the submission was a defense brief in which arguments against prospective charges were sent in writing to the commission. Lapidus told Merrill Lynch that if the firm wanted to submit a Wells, it had two weeks to do so. A confidential, twenty-page letter from the Wall Street firm arrived at SEC headquarters in mid-August. The document contended that neither Fisher, Louis Trujillo, nor Merrill Lynch itself should be charged with fraud, because the brokerage and its officials had acted responsibly in trying to control Matl.

  Merrill Lynch’s executives in Manhattan were deeply concerned about the prospect of SEC charges. A big retail brokerage depended on the trust of its customers; publicly filed fraud charges might undermine that trust severely. To press its defense inside the commission, the firm retained two lawyers with personal connections to the SEC: Robert Romano, a former enforcement division trial lawyer who had worked on Fedders’s early campaign against insider trading and Swiss-bank secrecy, and Irv Pollack, a former SEC commissioner and enforcement division chief who had been a staunch ally of Stanley Sporkin. Pollack now earned a lucrative living as a legal consultant to those who had trouble with the commission.

  Just after Labor Day, Romano called Bobby Lawyer’s office in San Francisco.

  I just want you to know that we’re going to do everything we can to defend ourselves at the commission, Romano said. I’ve put a call in to John Fedders and asked for a meeting in Washington and it looks like they’ll grant it. I’m letting your office know because I don’t want you to think we tried to go around you dishonestly.

  Lawyer said he appreciated the call. Of course, it was clear to the staff in San Francisco that Romano was trying to go around them—all of them knew that Merrill Lynch was likely to receive a more sympathetic hearing from the Republican appointees in Washington than from the former civil rights activists in San Francisco.

  On the appointed day, Romano and Pollack arrived at Fifth and D streets and were cleared upstairs. In a conference room they were greeted by a virtual army of enforcement division staff and other SEC lawyers, led by the towering Fedders.

  Merrill Lynch did everything that could be expected to curtail Matl’s conduct, Romano argued. When we determined that there were problems with his dealings with customers, we fired him—what more can a brokerage do?

  But Fedders and the others inundated Romano and Pollack with questions about Merrill Lynch’s internal compliance procedures, and about why it appeared that the firm had done little until an SEC investigator walked into the San Francisco branch and demanded to see the office files. When the meeting concluded, Romano and Pollack were handed a list of about twenty written “interrogatories,” or investigative questions, to be answered in writing and submitted later to the staff.

  A messenger lugged the answers into the SEC lobby on October 19, 1984—the brief weighed as much as a small phone book. There was a forty-page memo and about twenty-five exhibits attached. To show that Merrill Lynch had monitored Matl closely, the brief quoted from the memos Trujillo had written to his superiors detailing his concerns about Matl’s behavior. A copy of the fat document was sent out to Lawyer in San Francisco. Taking account of the Wall Street firm’s defense, his original memo was revised. But it contained the same recommendation: Merrill Lynch should be charged publicly by the commission for failing to supervise Victor Matl.

  The closed meeting room was packed when Lawyer and Lapidus arrived from San Francisco. Word of their impending confrontation with John Shad had circulated through headquarters, and an unusually large crowd of staff had come to the sixth floor to see who would prevail.

  Fedders, Lawyer, and Lapidus took their seats across from the five commissioners. Shad was in the center, flanked by James Treadway and Charles Marinaccio on one side, Charles Cox and Aulana Peters on the other.

  Whispered rumors about the case had risen to a crescendo in recent weeks. Shad denied it, but it was said that the chairman, through a subordinate, had ordered Lawyer’s case off the commission’s closely guarded calendar of closed meetings because he was opposed to naming Merrill Lynch as a defendant.

  Moreover, the counseling group under General Counsel Dan Goelzer—the cluster of attorneys organized in Harold Williams’s day to contain the power of Stanley Sporkin and which now reviewed all enforcement recommendations—had drafted a memo opposing charges against the Wall Street firm. It was said that lawyers in the counseling group had originally agreed with Bobby Lawyer’s proposal that Merrill Lynch be named, but had been told to take the opposite side by the chairman’s office. Again, Shad said it wasn’t so, but there was little
doubt where he stood on the issue. A few weeks earlier, Susan Pecaro’s case against Smith Barney had finally wound its way to a commission vote. At that meeting, all five commissioners had supported filing charges against Denny Herrmann and his boss in Rhinelander, Robert Heck. But Shad had argued vigorously against naming the Smith Barney firm as a defendant in the case, and it was only after a heated discussion that the staff’s recommendation to charge Smith Barney had prevailed by a 3 to 2 vote.

  For their part, Lawyer, Lapidus, and their staff back in San Francisco had little doubt that Shad had tried to quash charges against Merrill Lynch, and as they arrived at SEC headquarters for the climactic meeting, they wondered whether Fedders, too, would be against them. Feelings about the case ran high in the San Francisco office—they had put years of work into it; they had come to know Matl’s disgruntled customers well and shared their anger about the money they had lost. Fedders’s attitude was more clinical. After urging Lawyer to “be reasonable” and perhaps revise the memo’s recommendations about charging Merrill Lynch, the enforcement chief had taken a neutral stance, it seemed to some of the staff in San Francisco. They viewed Fedders as an ambitious wisp who would drift wherever the winds from Chairman Shad’s office blew. Lawyer had told his staff that he was going to fight this case without Fedders’s help. When the matter was taken off the calendar, he telephoned the office of Commissioner Peters, a black woman and Democrat about whom Lawyer had heard favorable comments from staff in Washington. He urged Peters to pressure Shad about the case. After a series of calls from Peters’s office to Shad’s, the matter had been restored to the closed calendar for a vote. Originally, Lawyer hadn’t been planning to fly to Washington for the argument—in routine cases it wasn’t necessary. But after all the back-channel lobbying, he and Lapidus decided it was essential that they go.